In the previous two articles, linked here and here, I started with some initial questions about IRAs and spent an entire article talking about the various options our spouses have when she/he inherits the IRA. But what about when non-spouses, including charities, handle this gift you gave them?
My answers will be as if the IRS will make the strictest interpretation of what they originally wrote. I believe they have flexed the rules a little (like when you have multiple beneficiaries of various ages) on splitting the IRA after your death, but I would rather say you be prepared for the worst and handle your matters with no confusion now while you are alive versus creating a mess that you will not be able to fix post-mortem.
Two other key points that don't relate to the rest of the article I will discuss now. If you are the inheritor of an IRA, you have up to 9 months to accept the gift or not. If you accept the gift, your first required RMD (I will talk about all distributions as taking just the minimum, but you can always take more), will be the year after the person has died. If you recuse yourself from the gift (which should be filed with the brokerage firm along with probate court), it will then go to the next beneficiary stated on the IRA form.
The second point is if the IRA owner had died before taking their RMD for the year, the inheritor will be required to take their respective RMD on the IRA owner's behalf. So if someone who is 83 years old passes away in January 2013, and did not take their RMD for the year, the inheritor will take the required RMD on their behalf (and the inheritor will file it on their tax return) and then all subsequent RMDs starting in 2014 will be based on the inheritor's life expectancy table. This will (hopefully) become much clearer in the examples below.
To try and put some names to our example, we have the following family and ages as of 2012:
Doctor Dividend, IRA owner, Age 75, value of IRA 12/31/2012: $900,000 and value of Roth IRA: $450,000
Penny Dividend, Wife, Age 74
Quarter Dividend, Child Age 44
Shekel Dividend, child of Quarter, Age 6
Rupee Dividend, child of Quarter, Age 1
Nickel Dividend, Child Age 42
Sacagawea Dividend, Child Age 39
Lira Dividend, Child of Sacagawea, Age 3
Charity: March of Dimes (could it be anything else?)
When the inheritor is not the spouse, RMDs are required. Period. Even on Roth IRAs, they are required. The Roth RMDs are tax-free, but they are still required. I cannot stress this enough that they are required or the inheritor will get hit with a massive tax penalty. The amount is determined by Table One of the IRS Life Expectancy Tables, linked here. You only need to look at this chart once for the rest of the distributions.
In this article, Doctor and Penny Dividend have decided that the IRAs will go to the children.
Scenario 1: Doctor Dividend fills out the brokerage form that says that Quarter, Nickel, and Sacagawea are the beneficiaries of the ONE IRA in"equal share," so each will get $300,000 from the IRA and $150,000 for the Roth. When Doctor Dividend dies (for the remainder of the article he has passed away in 2012), by strict IRS code, what is the RMD taken by each child?
Answer: You use the oldest inheritor as the basis for all RMDs, which is Quarter. He will be 45 in 2013, which is a divisor of 38.8 (linked here, see Table One on Page 86). So, each child will take the following RMD for 2013:
$300,000/38.8 = $7731.96 (taxable)
$150,000/38.8 = $3865.98 (tax-free)
For all subsequent years, you subtract ONE from the divisor (2014 = 37.8; 2015 = 36.8; etc.) until the account is extinguished. That is why I can say with confidence that no inherited account will last beyond 83-85 years of age of the beneficiary when you give it to someone under 50 years old. In this easy scenario, with the children close in age, the divisor is not a stretch IRA killer (Sacagawea's divisor would have been 43.6). But what if the beneficiaries were of massively different ages?
Scenario 2: Equal shares to Shekel, Rupee, Nickel, and Lira. What is the RMD taken for each inheritor?
Answer: The oldest inheritor is the basis for all RMDs, which would be Nickel (divisor for 43 years old = 40.7). But look what Doctor Dividend just did! He shrunk how long the grandkids could stretch the IRA by 36 YEARS! Shekel, at the ripe old age of 7, would have been able to stretch these IRAs for 75.8 years. Remember, after the first year, we just subtract one for every subsequent year thereafter. Thirty-six years of compounding just died with the doctor. Let's go through two more scenarios before I show you how to fix this problem:
Scenario 3: Equal Shares to Quarter, Nickel, Sacagawea, and the March of Dimes. What is the RMD for 2013?
Answer: You use the oldest inheritor as the basis for all RMDs. But we have a problem. The March of Dimes is not a person, so it does not have a life expectancy. The old rules apply where the inheritors have 5 years to exhaust the account (Note: The 5 years does not have to be taken in equal amounts. You could wait until the fifth year and remove everything then). The March of Dimes does not care, because it takes all the money it is given and pays no taxes, but the 3 children will care because instead of having 38.8 years to stretch it, like Scenario 1, they are now down to 5. Thanks Dad!!
Scenario 4: Like Scenario 1, where Quarter, Nickel, and Sacagawea are equal share inheritors, but Doctor and Quarter die together in an auto accident. Who gets what and what is the RMD?
Answer: The sad truth in this scenario is that Shekel and Rupee get nothing and Nickel and Sacagawea get the IRAs as a 50:50 split. So the RMD would be based on Nickel at the age of 43:
$450,000/40.7 = $11056.51 taxable
$225,000/40.7 = $5528.26 tax-free
The two children are not required in any way, shape, or form, to give their niece and nephew anything. It would have been different if two little Latin words were included on the beneficiary form. Those two words are: "in stirpes," which loosely translates as "within the family line." If those two words were on the form after each beneficiary's name, then Shekel and Rupee would have gotten the share, as I am sure their grandfather would have intended.
The real question that should be percolating in your mind is: How do I not screw this up and everyone gets what they should? The easiest answer is to make multiple IRA accounts with each person their own beneficiary. If we did that in scenario 3 (the charity example), the following would have occurred:
IRA 1 to Quarter (the only primary beneficiary on this IRA): $225,000/38.8 = $5798.97
IRA 2 to Nickel: $225,000/40.7 = $5528.26
IRA 3 to Sacagawea: $225,000/43.6 = $5160.55
IRA 4 to March of Dimes: $225,000 taken immediately due to no taxes
I did not show the Roths, but the same rules apply to splitting the account and distributions. Sacagawea would have 5 more years to stretch the money in this instance versus Scenario 1, because it is only her longer life expectancy that is being used for the calculations and not that of her older brother.
I'll end this article with one last twist: What if the inheritor of the IRA dies? Sacagawea inherits her father's IRA at age 40 and went to Table One and used the 43.6 years, and has followed the RMDs as described for the last 20 years. She put the primary beneficiary of this inherited IRA as Lira. At 60 years old, Sacagawea dies (she took her RMD for the year and the IRA is now valued at $750,000) and Lira is now 23. What does Lira do?
Answer: Lira DOES NOT go back to Table One and use her Life Expectancy. You only use Table One if you are a direct inheritor of the deceased's IRA. What Lira does is continue on the path of her mother's life expectancy. Here is what I mean in numbers:
At age 60, Sacagawea used the divisor of 23.6 for her RMD (43.6 originally - 20 years of taking RMDs) that she took for the year before she passed on. Lira will use 22.6 the next year. Hence, Lira's RMD will be:
$750,000/22.6 = $33185.84
Lira will continue to subtract one each year just like her mom has done until this account is exhausted. Any IRA that Lira directly inherits from her mother, she would use Table One. And of course, she would retitle the account as follows:
Sacagawea Dividend, IRA (deceased, October 12, 2033) F/B/O Lira Dividend, beneficiary
And name her own beneficiaries in case Lira passes on before these 22.6 years are exhausted.
To conclude, I hope this was helpful. As I said at the beginning of the article, I believe the IRS has allowed one IRA to be split post-mortem so each person uses their own life expectancy, but I would get the help of an IRA advisor to clarify and I would rather present the worst case scenario if things went terribly wrong. It makes matters much easier if you have several IRA accounts and each lineage is separate, making the hairiest part of inheritance, the split of who gets what, easily known to each beneficiary. And do make sure you have contingent beneficiaries as well for the flexibility of recusing the primary beneficiary (your child) so the IRA could be stretched to its maximum potential (a grand or a great-grandchild). Now that could be one heck of a gift.
